In a major victory for the trustee and victims of the Bernard Madoff Ponzi scheme, the Second Circuit again reversed District Judge Jed Rakoff, this time by holding that so-called inquiry notice is sufficient to show a lack of good faith by a transferee of a fraudulent transfer avoided under the Securities Investor Protection Act. Judge Rakoff had required the Madoff trustee to meet the higher standard of “willful blindness.”
The appeals court reversed Judge Rakoff on a second issue: Good faith is an affirmative defense to be pleaded by the defendant. In the complaint, the trustee is not required to plead facts showing the transferee’s lack of good faith.
Together, the rulings revive about 90 lawsuits against global financial institutions, hedge funds and other participants in the global financial markets. The decision allows Irving Picard, the Madoff trustee, to pursue the recovery of an additional $3.75 billion in stolen customer property, the trustee said in a statement.
The resurrected lawsuits will bring defrauded customers “as close as possible to recovering 100% of their losses,” the trustee said. A full recovery would be remarkable given that customers’ cash losses aggregate almost $19.5 billion.
The Madoff liquidation is being conducted in bankruptcy court under SIPA, which incorporates large swaths of the Bankruptcy Code, including Sections 548 and 550. The trustee filed hundreds of fraudulent transfer suits in the two years following the commencement of the liquidation in 2008.
The ‘Bad Faith’ Defendants
Most of the suits by the Madoff trustee were lodged against so-called “net winners,” meaning Madoff customers who took out fictitious profits. In reality, they were not receiving profits from investments. Rather, Madoff gave them money stolen from other investors because he never bought any securities with customers’ deposits.
The Madoff trustee benefited from the so-called Ponzi scheme presumption, where a transfer in a Ponzi scheme is presumed to be made with actual intent to defraud creditors under Section 548(a)(1)(A). The presumption is based on Bernie Madoff’s fraudulent intent, not the intent of the recipients of the fraudulent transfers.
Earlier in the Madoff liquidation, the Second Circuit held that net winners did not give value for receipt of fictitious profits and are therefore liable to pay back however much cash they took out within two years of bankruptcy in excess of the cash they invested. Because the return of a customer’s principal investments constitutes “value,” customers who took out less than they invested (so-called “net losers”) were not liable for receipt of fraudulent transfers.
In test cases decided by the Second Circuit on August 30, the Madoff trustee had reason to believe that the defendants either knew there was fraud or ignored enough red flags to be on inquiry notice. For lack of good faith, the Madoff trustee contended in his suits that the defendants were liable even for principal they took out.
The Decisions Below
There were three defendants-appellees in the Second Circuit. One was an initial transferee from Madoff who was being sued for $213 million. The other two were subsequent transferees being sued for $343 million and $6.6 million, respectively.
Early in the litigation, District Judge Rakoff withdrew the reference, reasoning that the suits involved securities law, of which SIPA arguably is part. In a decision in 2014, Judge Rakoff established two principles. SIPC v. BLMIS (In re Madoff Sec.), 516 B.R. 18 (S.D.N.Y. 2014).
First, District Judge Rakoff reasoned that a SIPA trustee must plead lack of good faith in the complaint with particularity. Otherwise, he said, placing the burden on the defendant would undercut SIPA’s goal of encouraging investor confidence.
Second, District Judge Rakoff required the trustee to plead the higher standard of “willful blindness” in proving lack of good faith because a securities investor has no inherent duty to inquire about his stockbroker.
Remanded to bankruptcy court, the bankruptcy judge dismissed the complaints under the pleading standards laid down by District Judge Rakoff. The bankruptcy court did not permit the trustee to amend the complaints, saying that the trustee could not plausibly show willful blindness.
The Second Circuit accepted a direct appeal.
Good Faith in the Statutes
Good faith appears in two sections of the Bankruptcy Code pertinent to the appeal.
Under Section 548(c), an initial transferee who “takes for value and in good faith has a lien on or may retain any interest transferred . . . to the extent that such transferee . . . gave value to the debtor in exchange for such transfer.” In a Ponzi scheme case like Madoff, the initial transferee’s lack of good faith requires giving back all transfers within two years of bankruptcy, not just net winnings.
Under Section 550(b)(1), a subsequent transferee is entitled to retain the transferred property if the subsequent transferee took “for value, . . . in good faith, and without knowledge of the voidability of the transfer avoided.” Section 550(b)(1) is applicable only to subsequent transferees.
In his complaint, the Madoff trustee alleged facts aiming to show that the three defendants all undertook investigations leading them to suspect that Madoff was conducting a fraud. For District Judge Rakoff, however, the allegations did not rise to the level of willful blindness.
The Reversal on Willful Blindness
Circuit Judge Richard C. Wesley reversed on willful blindness.
He defined inquiry notice as arising when “the facts the transferee knew would have led a reasonable person in the transferee’s position to conduct further inquiry into a debtor-transferor’s possible fraud.”
In comparison, District Judge Rakoff required willful blindness, which he defined as “a showing that the defendant acted with willful blindness to the truth, that is, he intentionally chose to blind himself to the red flags that suggest a high probability of fraud.”
Judge Wesley explained that the two standards differ in “degree and intent.” Someone who is willfully blind takes deliberate action to avoid confirming a high probability of wrongdoing. Inquiry notice, on the other hand, requires “knowledge of suspicious facts” that would induce “a reasonable person to investigate.”
District Judge Rakoff had invoked willful blindness because it is the standard for some securities law claims, and SIPA is part of securities law.
The Bankruptcy Code does not define “good faith,” so Judge Wesley looked to the “commonly understood meaning.” Before the Bankruptcy Code, he said that “good faith” meant “inquiry notice,” citing Circuit Judge Learned Hand for using that standard in 1914.
Judge Wesley concluded that “the plain meaning of good faith in Sections 548 and 550 of the Bankruptcy Code embraces an inquiry notice standard.” Other circuits, he said, “unanimously accept the inquiry notice standard.”
“The historical usage of the phrase ‘good faith’ (particularly as used in the context of fraudulent conveyance law), this Court’s prior case law, and the legislative history of the Bankruptcy Code all lead us to reject the heightened willful blindness standard,” Judge Wesley said.
The Same Standard in SIPA Cases
The defendants contended that willful blindness obtains in SIPA cases because inquiry notice is inconsistent with the standard in federal securities law.
Judge Wesley rejected the argument, observing that it had not been adopted by any other circuit court. He noted, among other things, that a Section 10(b) suit “for securities fraud is meaningfully different from a SIPA liquidation.”
The Burden of Pleading
Although good faith is an affirmative defense that the defendant must plead in an answer under Rule 8(c), District Judge Rakoff had placed the burden on the Madoff trustee in view of the “policy goals” of a SIPA liquidation.
Judge Wesley held that “the trustee is not required to plead a transferee’s lack of good faith” because “good faith is an affirmative defense under Sections 548 and 550 and . . . SIPA does not compel departing from the well-established burden-of-pleading rules.”
Other circuits, Judge Wesley said, “uniformly agree,” along with the Collier treatise. He found no “policy-based justifications for departing from Rule 8(c)(1) because placing the burden on the defendant “does not contradict the goals of SIPA.”
Judge Wesley vacated the judgments of the bankruptcy court and remanded for further proceedings.
The Concurrence
Circuit Judge Steven J. Menashi wrote separately.
He said that using “fraudulent transfer law rather than the law relating to preferences to promote an equal distribution among creditors . . . is questionable.” Because none of the defendants had challenged the Ponzi scheme presumption, he concurred in Judge Wesley’s opinion.
This writer finds the concurrence difficult to follow. Judge Menashi may have been saying that the defendants’ liability should have been judged by whether or not the transfers were preferences, had the defendants made the argument. To read the concurrence, click here.
Observations
The Second Circuit had reversed District Judge Rakoff two years ago by holding that Sections 548 and 550 can be applied extraterritorially to recover fraudulent transfers even if subsequent transfers occurred abroad. In re Picard, Trustee for the Liquidation of Bernard L. Madoff Investment Securities LLC, 917 F.3d 85 (2d Cir. Feb. 25, 2019). To read ABI’s report, click here.
The rulings by District Judge Rakoff on good faith set back the Madoff trustee even more in his efforts to recover on behalf of defrauded investors. More than five years into the liquidation, the decision by Judge Rakoff seemingly killed off about 90 lawsuits aiming to recover about $3.75 billion.
Rather than settle for little or nothing in the face of unfavorable decisions by District Judge Rakoff, the Securities Investor Protection Corp. supported the trustee’s decision to undertake seven years of further litigation to set up the test cases in the Second Circuit.
Already, the Madoff trustee has recovered almost $14.5 billion and has distributed more than $13.5 billion. He holds more than $900 million. The distributions so far represent almost 70% of investors’ cash losses.
In a major victory for the trustee and victims of the Bernard Madoff Ponzi scheme, the Second Circuit again reversed District Judge Jed Rakoff, this time by holding that so-called inquiry notice is sufficient to show a lack of good faith by a transferee of a fraudulent transfer avoided under the Securities Investor Protection Act. Judge Rakoff had required the Madoff trustee to meet the higher standard of “willful blindness.”
The appeals court reversed Judge Rakoff on a second issue: Good faith is an affirmative defense to be pleaded by the defendant. In the complaint, the trustee is not required to plead facts showing the transferee’s lack of good faith.
Together, the rulings revive about 90 lawsuits against global financial institutions, hedge funds and other participants in the global financial markets. The decision allows Irving Picard, the Madoff trustee, to pursue the recovery of an additional $3.75 billion in stolen customer property, the trustee said in a statement.